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    Locke Lord QuickStudy: Supreme Court Grants Certiorari To Hear South Dakota v. Wayfair: The Potential Implications for Financial Institutions

    Locke Lord Publications

    The Fate of Quill Physical Presence Standard
    This past January the Supreme Court of the United States granted certiorari to hear South Dakota v. Wayfair, Inc., Overstock.com, Inc., and Newegg, Inc.1 The South Dakota legislature passed a law that imposes a sales tax on out-of-state businesses that do not have a physical presence in the state, but receive revenue of over $100,000 a year or have “200 or more separate transactions.”2 The Supreme Court of South Dakota held that this law violated the physical presence standard set out in Quill Corp. v. North Dakota and the Commerce Clause.3 The Court held in Quill that states cannot impose a state tax on vendors that do not have a physical presence in the state.4 While the Quill standard has been a cornerstone of Commerce Clause jurisprudence for over two decades, many states, legal scholars and justices have questioned, in the digital age, the relevance and equity in requiring a business to be physically present in a state in order for such state to tax it.

    While there is increasing political desire by states deprived of tax revenue by internet sales to modify the Quill standard, the Court will have to rationalize the meaning of the commerce clause in the digital age with precedent in deciding Wayfair. The grant of certiorari has fueled speculation that there is sentiment on the Court to do so.

    Regulation and Physical-Presence
    As discussed earlier, physical presence determines whether a state can impose a sales tax on an entity. Since banks and other financial companies pay minimal sales tax, the Quill analysis does not directly apply to them. However, a decision in Wayfair may affect banks and financial services companies outside the tax context. To determine more precisely how financial institutions and banks may be affected by the Wayfair decision, an analysis of current case law on the subject regulating out-of-state entities is warranted.

    State and federal jurisprudence has examined the issue of a state’s ability to impose a regulation on an entity that does not have a physical presence in the regulating state. While there is no standard like Quill to define when physical presence may or may not exist, the courts have examined two main factors in determining whether enforcing a regulation on an entity without physical presence in a state is permissible.

    First, the courts weigh the balance between the benefits and protections the regulation provides its citizens and the burden it places on the out-of-state actor. The Tenth Circuit in Aldens, Inc. v. Ryan held that the state of Oklahoma could enforce its regulation upon an Illinois mail-order house that had no physical presence in Oklahoma, but only mailed catalogues to Oklahoma residents, because the burden placed upon the mail order house did not outweigh the state’s interest of “the cost of credit for goods sold to its residents.5 The court determined that the cost associated with complying with the regulation did not burden the company enough to infringe on its ability to conduct business.6 Distinguishing the holding in Aldens, the Eighth Circuit held in Pioneer Military Lending, Inc. v. Manning, that Missouri’s argument that it was protecting its citizens by imposing lender regulations was not applicable because the plaintiff had not made loans to citizens of Missouri, but to individuals just stationed on bases within the state.7 Additionally, the court held that the burden on the lender would be too great and possibly force it to go out of business, thus another reason to not impose the regulation upon the out-of-state lender.8

    Second, the courts examine where a transaction takes place and where an individual receives the money or benefits. In Otoe-Missouria Tribe of Indians v. New York State Dept, a New York court determined that the state of New York could regulate the Otoe-Missouria tribe’s lending even though the payday loan entity was on an Indian reservation.9 The Court argued that while Native American reservations are separate domestic entities, like states, and have sovereign control over their territories, the Otoe-Missouria reservation is not exempt from the New York regulation because the transactions did not occur on the reservation rather they finalized the transactions online and paid out to citizens of the state of New York.10 In Cash America Net Nevada, LLC v. Com., Dept. of Banking, the Pennsylvania Supreme Court held that an out-of-state lender is subject to licensing requirements and regulations under Pennsylvania’s Consumer Discount Company Act (CDCA) even though it is not located within the state.11 The reasoning in that case is, if the lender is determined to be an actor covered by the CDCA, regardless if the transaction is in person or on the internet, the entity must comply with regulations issued under it.12

    The existing case law discussed in the previous paragraphs show that unlike the Quill’s defined sales tax standard, states have more freedom to regulate businesses that are not physically present in their states. In the age of online business activity, it is very likely that an entity will do business in states where it is not physically located. In the event where an out-of-state entity may fall under a state’s regulation, current case law suggests that states have the right to impose their regulations to protect their citizens when these entities do business with citizens of the state. However, the case law, led by the Aldens’ balancing test weighing the burden on entities against the benefits to the states, overwhelming supports a regulating state’s ability to assert jurisdiction over and regulate out-of-state entities. What the cases often overlook is the significant compliance burden on national financial business which must constantly monitor compliance with the laws and regulations of, in some cases, 50 states.

    While case law is fairly established in this area, states have discussed and taken action on issues relating to the regulation of out-of-state financial companies doing business, especially online, in the regulating state. An example of this is with financial technology companies, commonly known as fintech companies. While there has been discussion about the Office of the Comptroller of the Currency (OCC) permitting fintech companies to be treated like federal banks by granting them limited bank charters, and, thus preemption status over state regulatory law, this has not yet occurred and fintech companies continue to be subjected to state regulatory law. In the midst of these discussions, many of the state regulatory entities have voiced their opinions against the OCC taking this measure,13 thus, putting the federal and state regulators at odds.

    Even in situations that are not intended to regulate out-of-state actors, states have already implemented regulations that affect financial companies located outside the regulating state. In 2017, New York issued NYSDFS Rule Part 504, which in conjunction with the New York’s Anti-Money Laundering regulations, requires financial institutions to more closely monitor their transactions to prevent money laundering.14 While this is aimed at protecting New York institutions, it is predicted that it will most likely affect institutions officed in other states because these transactions do not conform to state lines, thus requiring those out-of-state offices to comply with New York regulations.15 Additionally, there is speculation that regulations like New York’s will encourage other states to pursue similar paths in order to control financial practices that may disadvantage their citizens.16

    While the Aldens case is still the leading case in this area of law, we have recently seen by commentary or action, states willing to expand upon this definition to fit the modern era. They are not necessarily deviating from it, but rather tailoring it to respond to the world of online business.

    South Dakota v. Wayfair Ruling: Unintended Consequences for Financial Entities
    If the Court rules in favor of South Dakota in Wayfair, states may feel more comfortable imposing regulations on entities without physical presence. If the Court expands the definition of physical presence, it may well have opened the floodgates to state regulation of financial entities doing business in a foreign state without any physical presence. That is, the physical presence standard that has been tied to Quill’s restrictions could be decreased, thus possibly affecting how states classify traditionally out-of-state companies for regulation-purposes.

    As states may reclassify out-of-state companies for regulation purposes, it is likely that state courts will follow suit. For example, currently the Aldens regulation standard is a balancing test weighing the benefits for the regulating state versus the burden on the regulated company. If South Dakota prevails in Wayfair, it is likely that we will see this balancing test given more weight to the benefits’ side and less to the burdens placed on companies. Currently, the test leans slightly more in favor of the states, but with the possible success of Wayfair and a shift towards treating online companies more like brick-and-mortar businesses, the Aldens test will most likely lean significantly more in favor of states. Businesses will have a higher hurdle to clear in order to prove the regulation is burdening them, perhaps making it an almost impossible standard to meet. Ultimately, if Wayfair has this affect, then businesses should prepare to be subjected to not just the sales taxes of foreign states, but also increased regulations.

    Based on the current law, it has been shown that states have already put the concept of regulating out-of-state actors, especially financially-related institutions, into motion. If the state has provided a compelling reason as to how the regulation protects its citizens and that the transaction targets residents of the state, it appears that states have a lot of leeway to regulate. Lender organizations seem to have been hit particularly hard due to the nature of their work and transactions. If Wayfair goes in favor of South Dakota, it is likely that out-of-state lenders will continue to face the same obstacles when working within foreign states. On the other hand, because of the special treatment that banks receive under most state law, the fate of out-of-state banks may be less clear. The effect on them will more likely be focused on consumer protections. States may more closely scrutinize financial transactions and try to align them with the online activities done by businesses deemed to have physical presence under a sales tax situation. Additionally, states may regard them as having no physical presence, but argue that their transactions are akin to the already heavily-regulated lenders.

    As we have already seen by states’ sentiments and actions, there is momentum to subject all financial institutions, regardless of where they are physically present, to a state’s regulation if they do business in the state. In the event that Wayfair is decided in favor of South Dakota, we may see states push harder against measures like the one suggested by the OCC as well as follow the lead of states like New York in implementing regulations that cover all financial companies doing business with individuals and entities in a particular state. This could be a shift in favor of a broader view of physical presence and Wayfair could be the decision that changes or solidifies the power of states to regulate out-of-state financial businesses.

    Regardless of whether the Quill standard is upheld in Wayfair, we believe that the definition of “physical presence” will be expanded to include businesses and institutions that conduct business for individuals within a particular state. It is advisable for financial institutions to examine the online business they do in foreign states and gauge the states’ desire to implement broad interstate regulation. The growth of the shadow banking system will only encourage this trend particularly as some companies are discouraged to engage in practices harmful to a state’s citizens. The banking industry already heavily regulated will not likely oppose this trend and may encourage more regulation of their non-bank competitors.

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    [1] Scotus Blog, Supreme Court of the United States Blog

    [2] State of South Dakota v. Wafair Inc., Overstock.Com, Inc., and Newegg Inc., 2017 S.D. 56 (2017).

    [3] Id.

    [4] 504 U.S. 298 (1992).

    [5] 571 F.2d 1159, 1161-62 (10th Cir. 1978).

    [6] Id.

    [7] 509 F. Supp. 2d 974, 981 (2007).

    [8] Id.

    [9] Otoe-Missouria Tribe of Indians v. New York State Dept. (360)

    [10] Id.

    [11] 607 Pa. 432, 451 (2010).

    [12] Id.

    [13] Id.

    [14] “NYS DFS Part 504 Breakdown and Analysis”, Comply Advantage

    [15] “The Hidden Risks of NYSDFS Rule 504,” A&M

    [16] Id.

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